Prophet Without ProfitThinking Non-Linear

Nihilism is defined as “the total rejection of established laws and institutions.”  We are currently living through an age of financial nihilism.  Nihilism is also usually associated with radical elements that reject all authority.   I would submit that business elites and the political establishment are spawning political, legal and financial nihilism.

The Great Financial Crisis in the fall of 2008 led us on this path.  Perhaps it started with the best of intentions to save the financial system, but the unintended consequences of intended financial actions has negated any good from these efforts.  Let’s look at the particular elements of this sad condition:

• Zero Interest Rates – When a market sets interest rates, important information is conveyed to market participants.   Interest rates in a free market environment measure risk of repayment, a fair rate of return and the potential for inflation.  When the Federal Reserve anchors interest rates at near zero for “an extended period of time,” investors can no longer make long-term rationale investment decisions. Thus, money is likely to be mal-invested in uneconomical projects or speculation increases in economically sensitive commodities such as oil, metals and grain.
• Suspension of Mark to Market Accounting – At the start of the financial crisis, Congress leaned on the Financial Accounting Standards Board to suspend “mark to market” accounting (that is, the valuing of an asset in the most honest way, that is, taking into account its impairment or loss of value) .  In its most basic form, this is just plain dishonesty.   This dubious practice spread to banks in Europe as well.   Thus, there is no transparency in bank balance sheets; we (and even the banks themselves) simply can no longer believe the numbers on any institutional balance sheets. The result is that European banks are no longer willing to lend to one another.   Why?  These banks are now leveraged as much as 50-1, thus only a 2% drop in asset prices puts them at risk of failure.  We know that sovereign European bonds have dropped much more than 2%.   Thus, it is likely there is little or no real collateral to support a loan. See Art Cashin Exposes the Behind the Scenes Panic in Europe. With housing prices continuing in decline in the United States, I would suspect that many US banks too are hiding losses, and are in more dire straits than they or the Administration admits.
• Stress Tests – To reassure the public, both the Federal Reserve and the European Banking Authority ran stress tests on large banks.  Dexia (Belgium’s largest company) passed the most recent round of these “stress tests,” and then failed within three months.   Irish banks failed four months after their 2010 round of these tests.  See How Did Europe’s Bank Stress Test Give Dexia a Clean Bill of Health?  Bank of America and Citigroup shares have plummeted in 2011.  The Federal Reserve performed similar stress tests on these and other major American banks.  How credible were our “stress tests?”
• Eroding the Sanctity of Brokerage Accounts – The collapse of MF Global revealed that a brokerage firm could appropriate segregated customer accounts for its own uses.  It appears that MF Global circumvented US laws on account segregation by pledging customer accounts against a repo agreement in London.  Now, customers may never recover their monies.  See MF Global: The SERIOUS Issue Reaches Mainstream Media.  Karl Denninger points out that the standard brokerage agreement permits hypothecation and re-hypothecation, meaning that your brokerage account can be pledged to support a brokerage company or bank loan.  Since derivatives have preference over depositors, customer’s segregated accounts funds are at risk.
• Eroding the Sanctity of Real Property – To speed securitization of mortgages, the banks created an alternative mortgage registration system which bypassed centuries-old rules of settled property law.  A recent report documents the disastrous consequences:

… “thanks to the Mortgage Electronic Registry System’s (MERS) failure to accurately complete and/or publically record property conveyances in the frenzy of banks securitizing home loans and ins subsequent foreclosure actions, neighbors of a foreclosed property (with a sequential conveyance) as well as a foreclosed property itself will have unclear boundaries and clouded/unmarketable titles making it difficult, if not impossible, for these homeowners to sell their properties and for subsequent purchasers to obtain title insurance on the property.”

The report goes on to point out that courts have criticized the MERS model as flawed and have ruled against MERS’ stance to foreclosure. MERS is described as being “wholly inaccurate and not allowing homeowners to fight foreclosures because it [MERS] shields the true owner of a mortgage in public records.” See Study Claims that MERS Destroyed the Chain of Title and Consequently, the Housing Market

And worse yet, in sorting through the avalanche of subsequent foreclosures, mortgage servicers have filed fraudulent affidavits and false documentation. See e.g., Nevada Files First Criminal Charges in Robo-Signing Case

• Greek Credit Default Swaps – In good faith, buyers purchased credit default swaps on Greek bonds to hedge against a potential default.   The European authorities strong-armed banks and other investors to accept “voluntary” 50% haircuts on Greek bonds.  Because of this “voluntary” characterization the credit default swaps were not triggered.  With Spain, Ireland, Italy, Portugal and other countries suffering huge losses on their bonds, is it likely that investors will invest in these bonds when the hedge of a credit default swap can be negated through European financial authority fiat?   See Credit Default Swaps Useless as Hedge Against Default
• Federal Reserve Intervention in Markets – So far, when stock markets have faltered, the Federal Reserve has come to the rescue through quantitative easing (QE1& 2) or Operation Twist.  Thus, investors cannot know the true value of any stock since the Federal Reserve will not allow it to fall to a market-determined price.   Similarly, with zero interest rates and purchase of mortgage- backed securities, the Federal Reserve will not allow house values to fall to market clearing prices.
• Failure to Prosecute – Outside of a handful of insider trader prosecutions there has been no attempt to prosecute the malefactors of Wall Street. Excuses range from opining that the practices were legal, to the difficulty in building a case.  In the Savings and Loan crisis of the early 1990s the same difficulties existed, yet 1100 prosecutions were brought with 800 banks executives sent to jail.  See In Financial Crisis, No Prosecutions of Top Figures

Real World Consequences

We have eliminated price discovery from our markets.  We have neither permitted stocks to fall nor interest rates to rise.  Instead of prosecuting the banks that caused this problem, we shower them with interest free loans from the Federal Reserve so they can speculate or earn risk free profits by re-depositing funds with the Federal Reserve.  Thus, capital is being diverted from sound investments and used for speculative purposes or worse.

European financial authorities have destroyed the efficacy of hedging sovereign bonds in their handling of the Greek bond haircuts.  And thus another important market is being destroyed.

More ominously, Karl Denninger reports that in the wake of the MF Global failure, farmers are eschewing the hedging of crops through commodity futures and instead selling directly to food companies.  Thus, price stability will be diminished and consumers will ultimately pay higher prices.

The failure to “mark to market” and run honest stress tests has resulted in a freezing of interbank loans (a classic credit squeeze) and resulted in a silent run on banks, as UBS reports (bold face type in original text):

European banks are making great use of the ECB’s overnight deposit facility. Last night they parked $590 billion at the ECB breaking the record they had set the night before. They are clearly unwilling to lend to other European banks, highlighting the distrust and fear in the interbank marketplace.

The distrust on the streets is said to be growing also. Barroom gossip says that safe-deposit boxes are in a demand that borders on frenzy. They allow you to take your Euros and covert them into something of value (gold, Swiss Francs, etc.) and sock it away in a safe place.

 Others are said to be buying property in London and elsewhere lest you awake one day and discover that your Euros have reverted to drachmas or lira.

 Savvy bankers are said to be setting up personal and communal trusts domiciled in places like the Bahamas, the Caymans or the Isle of Jersey. Some banks are offering depository accounts denominated (and repayable) in alternate currencies like the dollar or the yen.

 We think a Lehman-like event would most likely be triggered by a run on a bank or a series of banks. The scramble for currency (value) protection among the public could turn into that bank run in the same way that a crowd can instantly turn into a mob. Watch the money flows out of Greece and Italy very carefully. The pot continues to bubble. See Art Cashin Exposes the Behind the Scenes Panic in Europe

If the Administration, The Federal Reserve and the European Authorities had set out to destroy capitalism, free markets and the current financial system, they could not have done a better job.   Free markets and a free people are intertwined.  The road to financial nihilism is ultimately a very dangerous path.